1

Chapter 6: Efficient Diversification

General thought: Risk comes from different places. Some risk comes
from common sources, like the economy. Other risk comes from
sources unique to each asset. This means that some kinds of risk can be
diversified.


Return and Risk for a Portfolio


First, need to know how much youve invested in each asset (w) as a percentage
of your total funds invested.


Expected return on a portfolio

+ + = =
i
i i P
r E w r E w r E w r E ... ) ( * ) ( * ) ( * ) (
2 2 1 1


In other words, portfolio expected return is always a weighted average of the
expected returns of the assets within the portfolio.

However, this is not true of portfolio standard deviation!


- Portfolio standard deviation depends on covariance / correlation between
each pair of assets within the portfoliohow much the movements between
each pair of assets offset each other.

- In general, portfolio standard deviation will be less than the weighted
average of the standard deviations of the individual assets within the
portfolio.



2

Covariance =
j i,
o : Tells you how much any pair (two) stocks (i and j) move
around together:

= =
s
r E s r r E s r s r r Cov )] ( ) ( )][ ( ) ( )[ Pr( ) , (
2 2 1 1 2 , 1 2 1
o


Prob. 1 2
Great .3 .2 .1
OK .5 .1 .2
Bad .2 - .05 .4


) 21 . 4 (. * ) 1 . 05 . ( * 2 . ) 21 . 2 (. * ) 1 . 1 (. * 5 . ) 21 . 1 (. * ) 1 . 2 (. * 3 .
2 , 1
+ + = o
= -.0033 + 0 + -.0057 = -.009


Correlation between Two Assets

The correlation coefficient standardizes covariance puts it into a form that tells
you how much two assets actually move together. Correlation coefficients are
scaled between 1 and +1:

j i
ij
ij
o o
o
=
=
) 1044 )(. 0866 (.
009 .
= -.995












3

Finally, we can use covariance to tell how risky the entire portfolio is


Variance of a portfolio

= =
=
N
i
N
j
j i j i P
w w
1 1
,
2
o o

If N=2,
2 , 1 2 1
2
2
2
2
2
1
2
1
2
2 o o o o w w w w
P
+ + =


If N=3,
2
3
2
3
2
2
2
2
2
1
2
1
2
o o o o w w w
P
+ + =
3 , 2 3 2 3 , 1 3 1 2 , 1 2 1
2 2 2 o o o w w w w w w + + +

Last step: Take square root of variance to get standard deviation.

4
Why are combinations of two risky assets concave?

- Depends on extent of correlation between assets making up the portfolio
Assume that we have two assets (1 and 2), and the extreme cases of perfect
positive ( 0 . 1
2 , 1
+ = ) and perfect negative ( 0 . 1
2 , 1
= ) correlation:

-Assume
) ( ) (
1 2
r E r E >
,
1 2
o o >



E(r
P
)


All Asset 2


0 . 1
2 , 1
=



Various weightings

0 . 1
2 , 1
+ =
of the two assets
result in these
portfolios.

0 . 1
2 , 1
=


All Asset 1

P
o



Observations:

- Perfect positive correlation: No benefit from diversification
(portfolio standard deviation = a weighted average of the parts)

- Perfect negative correlation: Zero-risk portfolio possible (specific weights
given on p. 157, footnote 2)


General idea: As you reduce correlation between pairs of assets, you reduce risk
for a given level of portfolio return. Since most assets are not perfectly
correlated, this means that various portfolio combinations of most two-asset
portfolios will lie on a curve that curves to the left.
5
Portfolio Variance and Diversification with numbers


Using
2 1 2 , 1 2 1
2
2
2
2
2
1
2
1
2
2 o o o o o w w w w
P
+ + =
:


Suppose that

05 . 0
2
2
2
1
= =o o
and
50 . 0
2 1
= = w w


05 . 05 . ) 50 )(. 50 (. 2 ) 05 . 0 ( 50 . ) 05 . 0 ( 50 .
2 , 1
2 2 2
o + + =
P


= .025 + 2 , 1

(.025)


Result: Variance of portfolio is less than the variance of each individual asset (.05)
as long as 2 , 1

< 1 (i.e. not perfectly correlated).

Ex: If 2 , 1

= 0,
2
P
o
= .025 < var(Asset 1) or var(Asset 2)
















6
Optimal Risky Portfolios with two risky assets and a risk-free asset

- Given two risky assets, we know that various portfolios curve to the left in
an expected return/standard deviation graph if they are less than perfectly
correlated

- We also know that combining any risky asset (or portfolio) with a risk-free
asset results in a straight line (the CAL) in the same graph.

Q: If you can combine the risk-free asset together with any combination of the
two risky assets, which combination of the two risky assets do you (and all
other investors) choose?

Answer: The tangency portfolio (P*) -- this portfolio has the steepest CAL.


CAL (P*)
E(r) A less risk averse investor
chooses this mix of P* and the
risk-free asset

(is a borrower)

Without a risk-free asset, a less risk
P* averse investor chooses this portfolio

Without a risk-free asset, a more risk
averse investor might choose this portfolio

A more risk averse investor would instead choose this
mix of P* and the risk-free asset (is a lender)
r
F



P
o

Note that risk averse investors are better off mixing the risky portfolio P*
with the risk-free asset (more risk-averse investors lend, less risk-averse
investors borrow.) Without the risk-free asset, each investor type chooses a
unique risky portfolio along the curve. With the risk-free asset, all investors
choose the same risky portfolio P* in combination with the risk-free asset on
the CAL. This results in higher Sharpe ratios for both investors (better risk
premium for a given amt of risk).
7
How do we know that investors will always prefer the tangency portfolio
(P*) in some combination with the risk-free asset?

- Investors are risk averse require a risk premium in exchange for
risk. Investors use the Mean Variance Criterion to pick assets
and portfolios:

Investment A is better than B if

B A
B A
and
r E r E
o o s
> ) ( ) (
and, one of these inequalities is strict

Points on the CAL are always better than points on the curved portion,
since investors can always get a better return with the same (or less) risk.


Q: Is there a formula for the weights of the optimal risky portfolio (P*) ?

Answer: Equation (6.10) on p. 159 (do not need to know this for any test!)


Final Q: Once you know how to put together the optimal portfolio P, how do you
allocate your money between P and r
F
?

Answer: Use the formula from Chapter 5:

2
*
) (
P
f P
A
r r E
y
o

=






8
Portfolios Using Many Risky Assets

- Given a fixed number of risky assets, you can form lots of portfolios

- Some of these portfolios form the minimum-variance frontier

- Of the minimum-variance frontier portfolios, efficient portfolios offer:

maximum return for a given amount of risk, and
minimum risk for a given return.

In general, points along the efficient frontier have to satisfy the two following
conditions:

Lowest
P
o
subject to some target E(r)
and Highest E(r) subject to some target
P
o



Efficient Frontier
E(r)

Global minimum variance
portfolio

Minimum variance frontier




P
o











9
- All of these risky portfolios combine with the risk-free asset in straight lines


E(r) CAL (optimal risky portfolio) Efficient Frontier






Some risky asset
P*
Global minimum variance
portfolio


r
F




P
o


- Result: One portfolio (P) dominates all of the other efficient portfolio on the
efficient set

- Investors who choose combinations of P and the risk-free asset get the
highest return for a given level of risk, compared to all other risky
portfolios

- In other words, all investors choose from points along the CAL passing
through portfolio P.

Separation Property: Risky portfolio selection is separate from how funds

are allocated between risky and risk-free assets









10
Portfolio Optimization in Practice

Typical asset classes:

.......................................................................................................................................................
...........................


Asset Allocation Matrix:
Cash/Cash
Equivalent
Equities Fixed Income
Mixed Cap Mutual
Funds
Other Classes
Cash Dow Industrial
Investment Grade
Corporate Bonds
Balanced
REITs Equity, Mortgage
and Hybrid
Money Market
Funds
S&P 500
Government/
Agency Bonds
Growth Other Alternative Classes
Treasury Bills NASDAQ 100 Treasury Bonds Income Natural Resources
Certificate of
Deposits (CDs)
Russell 2000
High Yield
Corporate Bonds
Growth & Income
Hard Assets: Commodities
Precious Metals
Canadian Dollars S&P Utilities Municipal Bonds
International
Equities
Hedge Funds
Japanese Yens Wilshire 5000
Mortgage backed
Securities
Sector Weightings
Hybrid Fixed Income &
Equity Strategies
World Money
Market Funds
International
Equities
International Bonds Total Return Convertibles



Typically, do not use utility analysis to identify optimal portfolio (P*) (where
you need to know the exact form of the utility function and the distribution of
returns):

- Maximize return for a given level of risk

- E.g. suppose your current portfolio is made up of 60% US stock, 40% US
bonds. Assume the expected return of this portfolio is 12.4% with a
standard deviation of 14.5%. Moving up to the efficient frontier
(involving a more diversified portfolio) results in the same risk but an
expected return of 14.7%.

11
- Maximize geometric mean

- E.g. suppose you have a 20-year holding period horizon. Your ideal
portfolio has the highest expected value of terminal wealth. This is the
portfolio with the highest geometric return, which results in the
following:

(1) Has the highest probability of reaching, or exceeding, any given
wealth level in the shortest possible time, and

(2) Has the highest probability of exceeding any given wealth level
over any given period of time.

This criteria *usually* results in a portfolio that is on the efficient set
(surprising?)


- Risk tolerance

- This technique involves maximizing a linear function of expected
return and variance scaled by risk tolerance, e.g.


Tolerance Risk
Variance
- Return Expected

This results in a maximized utility portfolio (similar to indifference
curve analysis)


- Safety first concentrate on bad outcomes

- Roy (1952) argued that investors should pick portfolios in order to
maximize the likelihood of getting above some threshold minimum
return. Once you have identified the efficient frontier, draw a straight
line from this minimum return tangent to the efficient frontier. Lower
thresholds result in optimal portfolios with less return / risk, etc.

)
L P
R Prob(R inimize M < ,

where R
P
is the return on the portfolio and R
L
is the minimum threshold return.
12
6.5 A Single-Index Asset Market

Remember the general thought: Risk comes from different places.
Some risk comes from common sources, like the economy. Other risk
comes from sources unique to each asset. This means that some kinds of
risk can be diversified.

- Identifying the tangency portfolio using the standard variance formula (as
before) can get complicated with lots of assets

- E(r)s = N
-
2
i
o
= N
-
ij
o
s = (N
2
N)/2 (Why?)
Total: (N
2
+3N)/2

With 100 Assets, need 10,300/2 = 5150 pieces of information to plot all 100 assets
on an E(r) / o graph.

Factor models simply this process.

Main idea: There are major economic forces that systematically move the prices of
all securities

Return on the market portfolio (index)

?

?










13
Using the idea that risks come from different sources, a single index model
assumes that actual returns can be separated into systematic (i.e. market-related)
and firm-specific parts here, the market (e.g. S&P500 index) is the source of
market-related movements in security i:

i M i i i
e R R + + = | o


- R
i
- excess return on security i
- R
M
- excess return on the market (i.e. the index)
-
i
e
- random error (Assume random errors are uncorrelated Why?)

- Beta - relative measure of an assets sensitivity to the market
index (or whatever factor youve used)

Think of Beta as the extent of a stocks market risk its average movement
when the market moves:
2
) , (
M
M i
i
R R Cov
o
| =
























14
Guess the Picture

R
i
R
i

A


B

R
M
R
M


R
i
R
i



D





R
M
R
M

C
Cumulative returns
0.96
0.98
1
1.02
1.04
1.06
1.08
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Time
V
a
l
u
e
S&P500
Energy West
ATC Group
15
Main Outcome of the Single-Index Model

We have a model for how returns move around, based on market-related and firm-
specific sources. From above, this is:

i M i i i
e R R + + = | o


What is the variance (risk) of these returns? This would be written as:

) ( ) (
i M i i i
e R Var R Var + + = | o


This can be simplified as follows (Equation 6.12):

) (
2 2 2 2
i M i i
e o o | o + =



Total risk = Market risk + firm-specific risk


Since unique movements are supposed to be random for each firm, any covariance
between a pair of assets should be due to market-related movements. Therefore,
we can calculate covariance between pairs of assets as follows:

2
) , ( ) , (
M j i M j M i j i
R R Cov R R Cov o | | | | = =

Suppose you are considering N risky assets. Using the single index model,
how many pieces of information do you need to find the efficient frontier?

- E(r)s =
) (
M i i
r E | o +

2N + 1
-
2
i
o
=
) (
2 2 2
i M i
e o o | +

N + 1
Total: 3N + 2

Thus, its a lot easier to figure out what the efficient frontier of risky assets is if
you use an index model.




16
Estimating an Index model

- For each day / week / month, record the excess return of the stock and the
excess return of the market. Do this for a long time (like a year) and then
plot all of the pairs of excess returns.

R
i
Line of Best Fit, or Security Characteristic Line

slope =
|




i
e



R
M

i
o







- The slope of the line of best fit is the stocks beta when the market moved
by 1%, on average this is how much the stock moved

- The vertical distance of each point away from the line is the residual, or e
i

the part of the stocks return that was firm-specific (i.e. was not related to
the market moving.)

The e
i
s (deviations) can be calculated as actual predicted return.

- The R-square statistic tells you how well all of the points fit the line.







17
Ex: Regress Microsofts returns on the index (S&P 500)

Micro P S Micro Micro Micro

e R R + + =
&
| o


Or, dep var = intercept + slope (indep var) + residual

Total return = Avg return not + Sensitivity of Microsoft + Movements
explained by mkt. to the market ( | ) unique to Microsoft
movements

Note: According to the assumptions of the market model, the intercept *should* be equal to
zero!


Variance of Residuals:
) (
2
Micro
e o

Greater variance says that actual return is more likely to be different from
expected estimate of firm-specific component of return.

Suppose we estimate the relationship between Microsoft and the S&P500 for five
years. We get:

Micro
o
= 0.29,
Micro
|
= 1.12

Movements in returns (total variance) are attributable to movements in the

index (scaled by Microsofts sensitivity) and movements of other things (the
i
e
s)
18
Diversification and the Single Index Model

For a single asset, we assume that
i M i i i
e R R + + = | o


Therefore, total risk is
) (
2 2 2 2
i M i i
e o o | o + =


For a portfolio, returns are similar:
p M p p p
e R R + + = | o

Get analogous relationship for risk:

) (
2 2 2 2
p M p p
e o o | o + =


Where:
| |
2
2

=
i i p
w| |
,

= ) ( ) (
2 2 2
i i p
e w e o o




Question: What can we say about the risk of a really well diversified
portfolio??

Outcome: For large N, 0 ) (
2

p
e o and the only remaining risk of portfolio is
market risk, i.e.
2 2 2
M p p
o | o =



p
o

Outcome:



Unique risk


M p
o |
---------------------------------------------
Total risk Market risk

N